Finance Act And The Way Forward For Debt Funds

The recent tax changes have created three categories in mutual fund taxation.

In a growing economy like India, with an expanding base of investors, any investment vehicle that is built on a solid base will find a way to grow. All the more so, for an investment category that is well regulated, transparent and provides liquidity in an otherwise not-so-liquid underlying market. It is in this context that one should take note of the tax changes introduced by the government recently. The Finance Act 2023 mandates that investments in growth option of debt schemes, irrespective of their holding period, be taxed as STCG, or short-term capital gains. STCG is taxed at the marginal slab rate of the investor. Other than people in lower income tax brackets, for most investors, it is the highest slab rate. What it effectively means is that the benefit of indexation, which was available for investments in debt funds till 31 March, has been taken away.

All fixed income investment options have now been brought on the same platform. Debt mutual funds (MFs) have lost their earlier advantage. Now, the comparison between fixed income investments will happen on merit. Bank term deposits are taxable as interest at your marginal slab rate. Bond coupon is taxable as interest at your marginal slab rate but the capital gains component, if you sell at a higher price prior to maturity, is taxed as capital gains at a lower rate. Debt MFs dividend option, now known as income distribution-cum-capital withdrawal option, was anyway taxable in the hands of the investor at the marginal slab rate. Now, the growth option will be taxed as STCG. Market linked debentures also will be taxed as STCG from 1 April.

Taxation being the same, the industry will find a path to grow. Here is an analogy that proves this. On 11 September 2020, markets regulator Securities and Exchange Board of India (Sebi) issued a circular on asset allocation in multi-cap funds, mandating minimum 25% allocation in large-cap, mid-cap and small-cap stocks. That would have meant drastic changes in the allocation of existing multi-cap funds. In less than two months, on 6 November 2020, Sebi issued a circular allowing a new fund category called flexi-cap fund. Something similar can be done in the current situation as well. The recent tax changes have created three categories in MF taxation. The first one will have equity allocation of less than 35%, which are mostly debt funds, apart from gold funds or international fund-of-funds. These will be taxed as STCG. The second will have equity allocation of more than 65%, which is taxed as in the case of equity. And, a third category, created by the amendment in the Finance Bill: Funds with equity allocation between 35% and 65% that will be taxed as debt as earlier i.e. with indexation benefit for a holding period of more than three years.

So, a category of funds can be positioned in the 35-65% equity bracket. If equity is kept on the lower side, say 35-40%, it would largely retain the debt character. This would be suitable for investors looking for a 3-year holding period and indexation benefit. The potential fund categories that may fit here are as follows:

Balanced hybrid funds: A Sebi circular issued on 6 October 2017 on fund categorization mentions a balanced hybrid fund with equity allocation of 40-60% of portfolio. The same circular allowed the category of aggressive hybrid funds with equity allocation of 65-80%. The circular, however, allowed only one of these two, i.e. balanced or aggressive. The MF industry opted for the aggressive variety as equity taxation is preferred. In view of the recent tax changes, Sebi may consider allowing both these categories, with balanced hybrid equity allocation at, say, 35-50%.

Conservative hybrid fund: This category will have equity allocation of 10-25%. If a little higher equity allocation is allowed, this category can be repositioned as 35% or more in equity.

Equity savings: In this, the combined allocation to equity (unhedged) and equity (hedged) is 65% or more. This can be softened so that the description is akin to debt funds.


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